Chapter 26-1 Prepared by Dan R. Ward Suzanne P. Ward University of Louisiana at Lafayette

Chapter 26-1

Prepared by

Dan R. Ward

Suzanne P. Ward

University of Louisiana at Lafayette

Chapter 26-2

Chapter 26

Incremental Analysis and Capital Budgeting

Accounting Principles, Ninth Edition

Chapter 26-3

Study ObjectivesStudy ObjectivesStudy ObjectivesStudy Objectives

1. Indicate the steps in management’s decision-making process.

2. Describe the concept of incremental analysis.

3.3. Identify the relevant costs in accepting an Identify the relevant costs in accepting an order at a special price.order at a special price.

4.4. Identify the relevant costs in a make-or-buy Identify the relevant costs in a make-or-buy decision.decision.

5.5. Give the decision rule for whether to sell or Give the decision rule for whether to sell or process materials.process materials.

Chapter 26-4

Study Objectives – ContinuedStudy Objectives – ContinuedStudy Objectives – ContinuedStudy Objectives – Continued

6.6. Identify the factors to consider in retaining Identify the factors to consider in retaining or replacing equipment.or replacing equipment.

7. Explain the relevant factors in whether to eliminate an unprofitable segment.

8. Determine which products to make and sell when resources are limited.

9.9. Contrast annual rate of return and cash Contrast annual rate of return and cash payback in capital budgeting.payback in capital budgeting.

10.10. Distinguish between the net present value Distinguish between the net present value and internal rate of return methods.and internal rate of return methods.

Chapter 26-5

Preview of ChapterPreview of ChapterPreview of ChapterPreview of Chapter

An important purpose of management An important purpose of management accounting is to provide managers with relevant accounting is to provide managers with relevant information for decision making. information for decision making.

Considers uses of incremental analysis and Considers uses of incremental analysis and capital budgeting in management’s decision capital budgeting in management’s decision making processmaking process

Chapter 26-6

Management’s decision-Management’s decision-making processmaking process

Accept special-price orderAccept special-price order

Make or buyMake or buy

Sell or process furtherSell or process further

Retain or replace equipment Retain or replace equipment

Eliminate unprofitable segmentEliminate unprofitable segment

Allocate limited resourcesAllocate limited resources

Evaluation processEvaluation process

Annual rate of returnAnnual rate of return

Cash paybackCash payback

Discounted cash flow: Discounted cash flow: NPV and IRRNPV and IRR

Incremental AnalysisIncremental AnalysisIncremental AnalysisIncremental Analysis Capital BudgetingCapital BudgetingCapital BudgetingCapital Budgeting

Incremental Analysis andIncremental Analysis andCapital BudgetingCapital Budgeting

Incremental Analysis andIncremental Analysis andCapital BudgetingCapital Budgeting

Chapter 26-7

Management’s Decision-Making Management’s Decision-Making ProcessProcess


Important management functionImportant management function

Does not always follow a set patternDoes not always follow a set pattern

Decisions vary in scope, urgency, and Decisions vary in scope, urgency, and importanceimportance

Steps usually involved in process include:Steps usually involved in process include:

SO 1: Identify the steps in management’s decision-making process.SO 1: Identify the steps in management’s decision-making process.

Illustration 26-1

Chapter 26-8



Considers both financial and non-financial Considers both financial and non-financial informationinformation

Financial informationFinancial information includes revenues and costs as well as their effect on overall profitability

Non-financial informationNon-financial information includes effect on employee turnover, the environment, or overall company image

SO 1: Identify the steps in management’s decision-making process.SO 1: Identify the steps in management’s decision-making process.

Chapter 26-9



Incremental Analysis ApproachIncremental Analysis Approach

Decisions involve a Decisions involve a choicechoice among alternative among alternative actionsactions

Financial data relevant to a decision are the Financial data relevant to a decision are the data data that vary in the future among alternativesthat vary in the future among alternatives

Both costs and revenues may vary or

Only revenues may vary or

Only costs may vary

SO 2: Describe the concept of incremental analysis.SO 2: Describe the concept of incremental analysis.

Chapter 26-10



Incremental AnalysisIncremental Analysis

Process used to identify the financial Process used to identify the financial data that change under alternative data that change under alternative courses of actioncourses of action

Identifies probable effects of decisions Identifies probable effects of decisions on future earningson future earnings

Also called Also called differential analysisdifferential analysis because it focuses on differencesbecause it focuses on differences


Chapter 26-11

How Incremental Analysis WorksHow Incremental Analysis WorksHow Incremental Analysis WorksHow Incremental Analysis Works

Basic ExampleBasic Example

Comparison of Alternative B with Alternative A:

Incremental revenue is $15,000 less under Alternative BIncremental cost savings of $20,000 is realizedAlternative B produces $5,000 more net income


Illustration 26-2

Chapter 26-12



Sometimes involves changes that seem Sometimes involves changes that seem contrary to intuitioncontrary to intuition

Variable costs sometimes Variable costs sometimes do not do not changechange under alternatives under alternatives

Fixed costs sometimes Fixed costs sometimes changechange between between alternativesalternatives

Incremental analysis Incremental analysis notnot the same as the same as CVP analysisCVP analysis

Chapter 26-13



Incremental analysis is the process of identifying Incremental analysis is the process of identifying the financial data thatthe financial data that

a.a. Do not change under alternative courses of Do not change under alternative courses of actionaction.

b. Change under alternative courses of action.

c. Are mixed under alternative courses of action.

d. None of the above.

Review Question

Chapter 26-14



BE26-2: Ming Company is considering two alternatives. Alternative A will have sales of $150,000 and costs of $100,000. Alternative B will have sales of $180,000 and costs of $120,000. Compare Alternative A to Alternative B showing incremental revenues, costs, and net income. Which alternative should you choose?

See notes page for solutionSee notes page for solution

Chapter 26-15

Types of Incremental Analysis Types of Incremental Analysis Types of Incremental Analysis Types of Incremental Analysis

Accept an order at a special priceAccept an order at a special price

Make or buyMake or buy

Sell or process furtherSell or process further

Retain or replace equipmentRetain or replace equipment

Eliminate an unprofitable business Eliminate an unprofitable business segmentsegment

Allocate limited resourcesAllocate limited resources


Chapter 26-16

Accept an Order at a Special PriceAccept an Order at a Special PriceAccept an Order at a Special PriceAccept an Order at a Special Price

Obtain additional business by making a major Obtain additional business by making a major price concession to a specific customerprice concession to a specific customer

Assumes that sales of products in other Assumes that sales of products in other markets are not affected by special ordermarkets are not affected by special order

Assumes that company is not operating at full Assumes that company is not operating at full capacitycapacity

SO 3: Identify the relevant costs in accepting an order at a special price.SO 3: Identify the relevant costs in accepting an order at a special price.

Chapter 26-17


ExampleExample

Customer offers to buy a special order of 2,000 units Customer offers to buy a special order of 2,000 units at $11 per unitat $11 per unit

No effect on normal salesNo effect on normal sales

No effect on plant capacity; currently operating at 80% No effect on plant capacity; currently operating at 80% which is 100,000 unitswhich is 100,000 units

Current variable manufacturing cost = $8 per unitCurrent variable manufacturing cost = $8 per unit

Current fixed manufacturing costs = $400,000 or $4 per Current fixed manufacturing costs = $400,000 or $4 per unitunit

Normal selling price = $20 per unitNormal selling price = $20 per unit

Based strictly on total cost of $12 per unit ($8 + $4), Based strictly on total cost of $12 per unit ($8 + $4), rejectreject offer as cost exceeds selling price of $11 offer as cost exceeds selling price of $11


Chapter 26-18


Example - ContinuedExample - Continued

Fixed costs do not change since within existing capacity – Fixed costs do not change since within existing capacity – thus thus fixed costs are not relevantfixed costs are not relevant

Variable manufacturing costs and expected revenues change Variable manufacturing costs and expected revenues change – thus – thus both are relevant to the decisionboth are relevant to the decision


Decision: Accept the offer; Income increases by $6,000Decision: Accept the offer; Income increases by $6,000

Illustration 26-3

Chapter 26-19


BE26-3: In Karnes Company it costs $30 per unit ($20 variable and $10 fixed) to make a product that normally sells for $45. A foreign wholesaler offers to buy 4,000 units at $23 each. Karnes will incur special shipping costs of $1 per unit. Assuming that Karnes has excess operating capacity, prepare an incremental analysis that indicates the net income (loss) Karnes would realize by accepting the special order. Should the order be accepted?



Chapter 26-20

Make or BuyMake or BuyMake or BuyMake or Buy

Example:The following costs are The following costs are incurred to incurred to make 25,000 25,000 switches:switches:

SO 4: Identify the relevant costs in a make-or-buy decision.SO 4: Identify the relevant costs in a make-or-buy decision.

AlternativelyAlternatively, the , the switches can be switches can be

purchased for $8 per for $8 per switch ($200,000)switch ($200,000)

Eliminates all variable Eliminates all variable costs of making costs of making

switchesswitches

Eliminates $10,000 of Eliminates $10,000 of fixed costs; however, fixed costs; however,

$50,000 remain$50,000 remain

Must decide whether to make the component Must decide whether to make the component parts or to buy them from othersparts or to buy them from others

Chapter 26-21


Example - ContinuedExample - ContinuedTotal manufacturing cost is $1 higher than purchase price

Must absorb at least $50,000 of fixed costs under either option


Decision: Continue to make switches Decision: Continue to make switches as purchasing adds $25,000 to costas purchasing adds $25,000 to cost

Illustration 26-5

Chapter 26-22


Opportunity CostOpportunity Cost

the the potential potential benefitbenefit that may be that may be obtained from obtained from following an following an alternative course of alternative course of actionaction

must be considered in must be considered in incremental analysisincremental analysis


Chapter 26-23


Example – ContinuedExample – ContinuedAssume that buying the switches allows the company to use the released capacity to earned $28,000 in additional income

The $28,000 lost income is an additional cost of making the switches – an opportunity cost


Decision: Buy the switches as company is $3,000 better Decision: Buy the switches as company is $3,000 better offoff

Illustration 26-6

Chapter 26-24



In a make-or-buy decision, relevant costs are:In a make-or-buy decision, relevant costs are:

a.a. Manufacturing costs that will be savedManufacturing costs that will be saved.

b. The purchase price of the units.

c. Opportunity costs.

d. All of the above.

Review Question

Chapter 26-25


BE26-4: Bartley Manufacturing incurs unit costs of $8 ($5 variable and $3 fixed) in making a sub-assembly part for its finished product. A supplier offers to make 10,000 of the part at $5.30 per unit. If the offer is accepted, Bartley will save all variable costs but no fixed costs. Prepare an analysis showing the total cost saving, if any, Bartley will realize by buying the part. What should they do?



Chapter 26-26

Chapter 26-27

Sell or Process FurtherSell or Process FurtherSell or Process FurtherSell or Process Further

May have option to sell product at a given May have option to sell product at a given point in production or to process further and point in production or to process further and sell at a higher pricesell at a higher price

Decision Rule:Decision Rule:

Process further as long as the incremental Process further as long as the incremental revenue from such processing exceeds the revenue from such processing exceeds the incremental processing costs incremental processing costs

SO 5: Give the decision rule for whether to sell or process materials SO 5: Give the decision rule for whether to sell or process materials further.further.

Chapter 26-28


Example:Costs to manufacture one unfinished table:Costs to manufacture one unfinished table:

Direct materialsDirect materials $ 15$ 15Direct laborDirect labor $ 10$ 10Variable manufacturing overheadVariable manufacturing overhead $ 6$ 6Fixed manufacturing overheadFixed manufacturing overhead $$ 4 4

Manufacturing cost per unitManufacturing cost per unit $35

Selling price of unfinished unit is $50Selling price of unfinished unit is $50

Used capacity used to finish tables to sell for $60 per tableUsed capacity used to finish tables to sell for $60 per table

Relevant unit costs of finishing table:Relevant unit costs of finishing table:

Direct materials increase $2Direct materials increase $2Direct labor increase $4Direct labor increase $4Variable overhead increase $2.40 (60% of direct Variable overhead increase $2.40 (60% of direct

labor)labor)No change in fixed overheadNo change in fixed overhead


Chapter 26-29


Example – ContinuedExample – Continued

Decision: Process furtherDecision: Process furtherIncremental revenue ($10) exceeds incremental Incremental revenue ($10) exceeds incremental

processing costs ($8.40); income increases $1.60 per processing costs ($8.40); income increases $1.60 per unitunit

Illustration 26-8


Chapter 26-30


BE26-5: Stanton Inc. makes unfinished bookcases that it sells for $60. Production costs are $30 variable and $10 fixed. Because it has unused capacity, Stanton is considering finishing the bookcases and selling them for $72.Variable finishing costs are expected to be $8 per unit with no increase in fixed costs. Prepare an analysis on a per unit basis showing whether Stanton should sell unfinished or finished bookcases.



Chapter 26-31

Retain or Replace EquipmentRetain or Replace EquipmentRetain or Replace EquipmentRetain or Replace Equipment

Example:Assessment of replacement of factory machine:Assessment of replacement of factory machine:

Old MachineOld Machine New MachineNew Machine

Book ValueBook Value $ 40,000 $ 40,000CostCost $ 120,000 $ 120,000Remaining useful lifeRemaining useful life four years four years four years four yearsSalvage valueSalvage value -0- -0- -0- -0-

Variable manufacturing costs decrease from $160,000 to Variable manufacturing costs decrease from $160,000 to $125,000 if new machine purchased$125,000 if new machine purchased

SO 6: Identify the factors to consider in retaining or replacing SO 6: Identify the factors to consider in retaining or replacing equipment.equipment.

Chapter 26-32



Decision: Replace the EquipmentDecision: Replace the EquipmentThe lower variable costs due to replacement more than The lower variable costs due to replacement more than

offset the cost of the new equipmentoffset the cost of the new equipment

Illustration 26-9


Chapter 26-33


Additional ConsiderationsAdditional Considerations

The book value of old machine The book value of old machine does not affect the decision.does not affect the decision.

Book value is a sunk cost.Book value is a sunk cost.Costs which cannot be Costs which cannot be changed by future decisions changed by future decisions (sunk cost) are not relevant in (sunk cost) are not relevant in incremental analysis.incremental analysis.

However, any trade-in allowance or cash disposal value of the existing asset is relevant.


Chapter 26-34


SO 5: Give the decision rule for whether to SO 5: Give the decision rule for whether to sell or process materials further.sell or process materials further.

The decision rule in a sell-or-process-further decision The decision rule in a sell-or-process-further decision is:is:

Process further as long as the incremental Process further as long as the incremental revenue from processing exceeds:revenue from processing exceeds:

a.a. Incremental processing costsIncremental processing costs.

b. Variable processing costs.

c. Fixed processing costs.

d. No correct answer is given.

Review Question


Chapter 26-35

Eliminate an Unprofitable SegmentEliminate an Unprofitable SegmentEliminate an Unprofitable SegmentEliminate an Unprofitable Segment

Key: Key: Focus on Relevant CostsFocus on Relevant Costs

Consider effect on related product lines

Fixed costs allocated to the unprofitable segment must be absorbedmust be absorbed by the other segments

Net income may decreasedecrease when an unprofitable segment is eliminated

Decision Rule:

Retain the segment unless fixed costs Retain the segment unless fixed costs eliminated exceed contribution margin losteliminated exceed contribution margin lost

SO 7: Explain the relevant factors in SO 7: Explain the relevant factors in whether to eliminate an unprofitable whether to eliminate an unprofitable

segment.segment.

Chapter 26-36


ExampleExample::Martina Company manufactures three models of tennis rackets:

Profitable lines: Pro and MasterUnprofitable line: Champ

Condensed Income Statement data:

Should Champ be eliminated?Should Champ be eliminated?

Illustration 26-10


segment.segment.

Chapter 26-37



If Champ is eliminated, allocate its $30,000 fixed costs:

2/3 to Pro and 1/3 to Master

Revised Income Statement data:

Total income has decreaseddecreased by $10,000

Illustration 26-11


segment.segment.

Chapter 26-38



Incremental analysis of Champ provided the same results: Do Not Eliminate Champ

Decrease in net income is due to Champ’s contribution margin ($10,000) that will not be realized if the segment is discontinued.

Illustration 26-12


segment.segment.

Chapter 26-39


If an unprofitable segment is eliminated:

a. Net income will always increase.

b. Variable expenses of the eliminated segment will have to be absorbed by other segments.

c. Fixed expenses allocated to the eliminated segment will have to be absorbed by other segments.

d. Net income will always decrease.

Review Question


segment.segment.

Chapter 26-40


BE26-7: Derby, Inc. manufactures golf clubs in three models. For the year, the Eagle line has a net loss of $20,000 from sales $200,000, variable expenses $180,000, and fixed expenses $40,000. If the Eagle line is eliminated, $34,000 of fixed costs will remain. Prepare an analysis showing whether the Eagle line should be eliminated.



segment.segment.

Chapter 26-41

Allocate Limited ResourcesAllocate Limited ResourcesAllocate Limited ResourcesAllocate Limited Resources

Resources are always Resources are always limitedlimited

Floor space for a retail firmRaw materials, direct labor hours, or machine capacity for a manufacturing firm

Management must decide which products to make which products to make and sell to maximize net and sell to maximize net incomeincome

SO 8: Determine which products to make and SO 8: Determine which products to make and sell when resources are limited.sell when resources are limited.

Chapter 26-42


Example:Example: Collins Company manufacturesdeluxe and standard pen andpencil sets

Limiting resource:3,600 machine hours per month

Deluxe set has higher contribution margin: $8

Standard set takes fewer machine hours per unit


Illustration 26-13

Chapter 26-43


Example: - ContinuedExample: - Continued Must compute contribution margin per unit of limited resource

Standard sets have higher contribution margin per unit of limited resources


Decision: Decision: Shift sales mix to standard sets or increase machine capacity

Illustration 26-14

Chapter 26-44


Example: - ContinuedExample: - Continued

Alternative: Increase machine capacity from 3,600 to 4,200 machine hours

To maximize net income, all the additional 600 hours should be used to produce standard sets


Illustration 26-15

Chapter 26-45

Capital BudgetingCapital BudgetingCapital BudgetingCapital Budgeting

The process of making capital expenditure The process of making capital expenditure decisions in business is known asdecisions in business is known as

Capital BudgetingCapital Budgeting

The amount of possible capital expenditures usually exceeds the funds available for such expenditures

Capital budgeting involves choosing among various capital projects to find the one(s) that will

Maximize a company’s return on investmentMaximize a company’s return on investment

Chapter 26-46

Evaluation ProcessEvaluation ProcessEvaluation ProcessEvaluation Process

Many companies follow a carefully prescribed Many companies follow a carefully prescribed process in capital budgeting.process in capital budgeting.

At least once a year:

Proposals are requested from each department

The capital budgeting committee screens the proposals and submits its findings to the officers of the company

Officers select projects and submit list to the board of directors for approval

Chapter 26-47


Providing management with Providing management with relevant data for capital budgeting relevant data for capital budgeting decisions requires familiarity with decisions requires familiarity with quantitative techniques.quantitative techniques.

The most common techniques are:

Annual Rate of ReturnAnnual Rate of Return

Cash PaybackCash Payback

Discounted Discounted Cash FlowCash Flow

Chapter 26-48


These techniques will be illustrated using the following These techniques will be illustrated using the following data for Tappan Company:data for Tappan Company:

Investment in new equipment: $130,000Useful life of new equipment: 10 yearsZero salvage and straight-line depreciationThe expected annual revenues and costs of the new product that will be produced from the investment are: Illustration 26-16

Chapter 26-49

Annual Rate of ReturnAnnual Rate of ReturnAnnual Rate of ReturnAnnual Rate of Return

The annual rate of return technique is based The annual rate of return technique is based directly on accounting datadirectly on accounting data

It indicates the profitability of a capital It indicates the profitability of a capital expenditureexpenditure

The formula is:The formula is:

The expected annual net income is from the projected Income Statement

SO 9: Contrast annual rate of return and cash SO 9: Contrast annual rate of return and cash payback in capital budgeting.payback in capital budgeting.

Illustration 26-17

Chapter 26-50


The average investment is derived from the The average investment is derived from the following formula:following formula:

For Tappan Company the average investment is:


[($130,00 + $0) ÷ 2] = $65,000

Illustration 26-18

Chapter 26-51


The expected rate of return for Tappan The expected rate of return for Tappan Company’s investment in new equipment is:Company’s investment in new equipment is:

The decision rule is:


A project is acceptable if its rate of return is greater than management’s minimum rate of return. When choosing among several acceptable projects, the project with the higher rate of return is generally more attractive.

$13,000 ÷ $65,000 = 20%

Chapter 26-52


Principal advantages of the annual rate of return technique:

Simplicity of calculationsManagement’s familiarity with accounting terms used in the calculation

Major limitation of the technique:

It does not consider the time value of moneyIt does not consider the time value of money

As noted in Appendix C, recognition of the time value of money can make a significant difference between the present and future values of an investment.


Chapter 26-53

Cash PaybackCash PaybackCash PaybackCash Payback

Identifies the time period required to recover the cost of the investment

Uses the net annual cash flow produced from the investment

Net annual cash flow can be approximated by taking net income and adding back depreciation

The formula for computing the cash payback period is:


Illustration 26-19

Chapter 26-54


Example:Example:

Tappan Company has net annual cash inflows of $26,000 ( Net Income $13,000 + Depreciation $13,000)

The cash payback period is:


$130,000 ÷ $26,000 = 5 $130,000 ÷ $26,000 = 5 yearsyears

Chapter 26-55


Example:Example: Chen Company has uneven net annual cash inflows Now the cash payback period is determined when the cumulative net cash flows equal the cost of the investment


Illustration 26-21

Chapter 26-56


SO 9: Contrast annual rate of return and SO 9: Contrast annual rate of return and cash payback in capital budgeting.cash payback in capital budgeting.

Which of the following is Which of the following is incorrectincorrect about the about the annual rate of return technique:annual rate of return technique:

a.a. The calculation is simpleThe calculation is simple.

b. The accounting terms used are familiar to management.

c. The timing of the cash inflows is not considered.

d. The time value of money is considered.

Review Question

Chapter 26-57


BE26-9:BE26-9: Adler Company is considering Adler Company is considering purchasing new equipment for $300,000. It is purchasing new equipment for $300,000. It is expected that the equipment will produce annual expected that the equipment will produce annual net income of $10,000 over its 10-year useful life. net income of $10,000 over its 10-year useful life. Annual depreciation will be $30,000.Annual depreciation will be $30,000.

Compute the cash payback period.

Chapter 26-58


First,First, calculate net annual cash inflows: calculate net annual cash inflows:

Net income + depreciationNet income + depreciation

$10,000 + $30,000 = $40,000$10,000 + $30,000 = $40,000

Second,Second, divide capital investment by annual divide capital investment by annual cash flowscash flows

$300,000 ÷ $50,000 = 6 years$300,000 ÷ $50,000 = 6 years

Chapter 26-59

Chapter 26-60

Discounted Cash FlowDiscounted Cash FlowDiscounted Cash FlowDiscounted Cash Flow

Discounted cash flow techniques generally recognized as best approach to making capital budgeting decisions

Techniques consider both:Estimated total cash inflows, andThe time value of money

Two methods generally used with the discounted cash flow techniques are

Net Present Value Method

Internal Rate of Return Method

SO 10: Distinguish between the net present SO 10: Distinguish between the net present value and internal rate of return methods. value and internal rate of return methods.

Chapter 26-61

Net Present Value MethodNet Present Value MethodNet Present Value MethodNet Present Value Method

NPV method compares the present value of present value of the cash inflowsthe cash inflows to the capital outlay required by the investment

The differencedifference between the two amounts is referred to as the net present valuenet present value

The interest rate used to discount the cash flow is the required minimum rate of return

A proposal is acceptable when the NPV is zero or positivezero or positive

The higher the positive NPV, the more attractive the investment


Chapter 26-62


Net Present Value Decision CriteriaNet Present Value Decision Criteria


Illustration 26-22

Chapter 26-63


Example: Equal Annual Cash FlowsExample: Equal Annual Cash Flows

Annual cash flows of $26,000 uniform over asset’s useful life

Calculation of present value of annual cash flows (annuity) at 2 different discount rates:


Illustration 26-23

Chapter 26-64


Example: Equal Annual Cash Flows - ContinuedExample: Equal Annual Cash Flows - Continued

Analysis of proposal using net present values

NPV positive for both discount rates

Accept proposed capital expenditure at either discount rate


Illustration 26-24

Chapter 26-65


Example: Unequal Annual Cash FlowsExample: Unequal Annual Cash Flows

Different cash flows each year over asset’s useful life; calculation of PV of annual cash flows at 2 different discount rates:


Illustration 26-25

Chapter 26-66


Example: Unequal Annual Cash Flows - Example: Unequal Annual Cash Flows - ContinuedContinued

Analysis of proposal using net present values

NPV positive for both discount rates

Accept proposed capital expenditure at either discount rate


Illustration 26-26

Chapter 26-67

Internal Rate of Return MethodInternal Rate of Return MethodInternal Rate of Return MethodInternal Rate of Return Method

IRR method finds the interest yield of the potential investment

IRR – rate that will cause the PV of the proposed capital expenditure to equal the PV of the expected annual cash inflows

Two steps in method

1. Compute the interval rate of return factor

2. Use the factor and the PV of an annuity of 1 table to find the IRR.


Chapter 26-68


Example: Example:

Step 1: The formula for computing the IRR factor:

IRR factor for Tappan Company, assuming equal annual cash inflows:

$130,000 ÷ $26,000 = 5.0$130,000 ÷ $26,000 = 5.0


Illustration 26-27

Chapter 26-69


Example - Continued Example - Continued

Step 2: IRR is the discount factor closest to the IRR factor for the time period covered by the annual cash flows.

Closest discount factor to 5.0 is 5.01877; thus IRR is approximately 15%


Chapter 26-70


Compare IRR to management’s required minimum rate of return

Decision Rule:Accept the project when the IRR is equal to or greater than the required rate of return.

Assuming a minimum rate of return for Tappan of 10%, project is accepted since IRR of 15% is greater than the required rate.


Chapter 26-71



Illustration 26-28

Chapter 26-72

Comparison of Discounted Cash Flow Comparison of Discounted Cash Flow MethodsMethods

Comparison of Discounted Cash Flow Comparison of Discounted Cash Flow MethodsMethods


Illustration 26-29

Chapter 26-73


SO 10: Distinguish between the net present SO 10: Distinguish between the net present value and internal rate of return methods.value and internal rate of return methods.

A positive net present value means that the:A positive net present value means that the:

a.a. Project’s rate of return is less than the Project’s rate of return is less than the cutoff ratecutoff rate.

b. Project’s rate of return exceeds the required rate of return.

c. Project’s rate of return equals the required rate of return.

d. Project is unacceptable.

Review Question

Chapter 26-74

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Chapter 26-1 Prepared by Dan R. Ward Suzanne P. Ward University of Louisiana at Lafayette